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New financial year, new approaches to asset impairment testing
08 Apr 2021The economic impacts of COVID-19 will continue to persist well into 2021. Our borders remain substantively closed and the nationwide roll out of a COVID-19 vaccine is yet to reach critical mass in New Zealand.
This means that teams which perform inhouse impairment testing need to consider how the ripple effects of the pandemic will influence their financial statements over the next 12 months.
What are the key considerations for asset impairment testing?
Assets measured at amortised cost must be tested for impairment when indicators exist or, in the case of goodwill and indefinite life intangible assets, at least annually. An impairment charge is booked to profit or loss when the carrying value of an asset exceeds its recoverable amount. Recoverable amount is determined based on the higher of an assets value in use (VIU) or fair value less costs of disposal (FVLCD).
Is COVID-19 pandemic an impairment indicator at the reporting date?
Since the declaration of a global pandemic in early 2020, businesses have needed to consider COVID-19 as a potential impairment indicator for financial reporting purposes.
What are the most relevant indicators to the COVID-19 pandemic?
Detailed examples of impairment indicators are included in NZ IAS 36.The most relevant indicators are listed below.
External indicators
- Observable indicators of decrease in value
- Significant changes with an adverse effect on the entity, it’s economic environment or market have occurred during the pandemic
- The carrying amount of the entity’s net assets is more than its market capitalisation
Internal indicators
- Assets becoming idle
- Evidence that economic performance is worse than expected
- Plans to dispose of an asset
- Plans to restructure
Given the prevalence of certain indicators, we encourage management to consider and carefully document these factors along with the consequences they might have on financial statements.
Which assets are likely to be impacted?
Long-lived assets including:
- right-of-use assets arising from lease contracts
- property, plant, and equipment
- intangible assets.
NZ IAS 36 requires these assets be tested where indicators of impairment are identified. This analysis is performed for individual assets if they generate cash inflows independently from other assets. For other assets and goodwill, testing is generally achieved by reference to the cash generating unit (CGU) that the relevant asset belongs to. In some cases, it is possible to reliably estimate fair value less costs of asset disposal (FVLCD) at an individual asset level, but value in use (VIU) only at CGU level. If the FVLCD estimate shows there is no impairment, it is not necessary to test the CGU.
Remember, goodwill and indefinite life intangible assets must be tested for impairment at least annually, irrespective of whether indicators exist or not.
Entities may have assets that are subject to impairment testing that do not qualify as long-lived assets and are not financial assets. These assets should be assessed for impairment as they could be impacted by the COVID-19 pandemic, particularly if these amounts reflect historical transactions with third parties where the creditworthiness of these third parties is now called into question. For example, a business might have prepaid for goods or services, but the counterparty may no longer be able to provide these or to refund the payment.
How is COVID-19 likely to impact the impairment test?
The recoverable amount is the higher of VIU and FVLCD and COVID-19 will often affect both. Many entities start by estimating the VIU; if it exceeds the carrying value, there is no need to determine the FVLCD (and vice versa). However, if VIU indicates an impairment, then FVLCD should also be estimated, unless facts and circumstances indicate that FVLCD would not be materially higher than VIU, or it cannot be estimated reliably.
The main building blocks of the VIU estimate are:
- cash flow projections
- an appropriate discount rate and adjustments to incorporate variability
- uncertainty and other factors that would reflect in pricing the asset or CGU.
These changes will also be affected by the COVID-19 pandemic and can be reflected by adjusting either:
- the discount rate
- the cash flows (including the long-term growth assumptions).
Ordinarily, the application of a risk-adjusted discount rate approach is common. However, given the levels of uncertainty in the current environment, the risk-adjusted expected cash flow approach is often preferable as it involves more explicit consideration of the wider range of possible future scenarios and outcomes.
Whichever approach is applied, management must ensure the outcome reflects the risks, uncertainties and other factors that would influence market participants’ pricing decisions. It is equally important to ensure that cash flows and discount rate concepts are aligned to avoid double-counting the risk factors caused by the pandemic.
How will it impact the cash flow forecasts?
Many businesses are experiencing major interruptions to their operations, with rapid declines in net cash flows and earnings, and there is ongoing uncertainty over the duration of this disruption its longer-term impact. The VIU cash flow forecasts must nonetheless reflect assumptions about these impacts based on facts and circumstances at financial year-end. These assumptions should be explicit, clear and evidenced. In the current environment it is unlikely to be reasonable for most entities to base their estimates on their performances during past periods.
As the situation develops, more information about the severity of the financial impact may become available after financial year-end but before the date of the approval for the financial statements. While organisations are required to determine amounts based on their knowledge of events at the reporting date as a starting point, information obtained after the reporting date can be considered if such conditions existed at the reporting period end. Significant professional judgement of all the relevant facts and circumstances are required to make this assessment.
Entities may face real challenges in reflecting the COVID-19 pandemic impact in a single set of forecast cash flows due to high levels of uncertainty. Companies should therefore consider developing multiple scenarios and applying probabilities for each to arrive at the expected cash flows. It’s important to note that not all industries are affected in the same way, particularly when calculating risk-adjusted expected cashflow. Reporting entities should consider longer term scenarios based on market research and insights available to management to support their case; this could demonstrate a reduction of cash flows in the current year but a recovery at some point in the future (or the opposite if current performance is above trend as evident in some industries). Management teams’ external advisors should have access to research, data and insights to quantify these scenarios.
What about fair value less costs of disposal (FVLCD)?
When estimating FVLCD, observable and arm’s length transactions should be referred to as much as possible. Prices for fire-sales of assets or asset groups may not reflect an orderly transaction. In the current environment, it may be more difficult to determine the current fair value based on market evidence due to a lack of recent arms-length transactions between market participants as they are defined in NZ IFRS 13 Fair Value Measurement.
If management uses a valuation technique to estimate FVLCD, the inputs and assumptions should only represent information that would be available to market participants at the reporting date. Information not available at the reporting date (based on normal access and due diligence for a transaction involving the asset(s) in question) cannot affect fair value. When unobservable inputs are used for fair value estimates, management needs to assess how the available information about the COVID-19 pandemic at the reporting date would influence market participants’ pricing decisions.
What about useful life?
Detailed and explicit VIU cash flow forecasts are generally required to be for no more than five years. Beyond the detailed forecasting period, NZ IAS 36 requires an extrapolation using a steady or declining long-term growth rate. The impact of the COVID-19 pandemic may mean that reporting entities will now be forced to use the asset in its current condition for a period extending well beyond five years. However, NZ IAS 36 permits using a detailed forecast period of more than five years only if management cannot demonstrate an ability to forecast accurately over such a period. Conversely, long-term growth rate assumptions applied previously may no longer be suitable, particularly if the economic impact of COVID-19 is viewed as being more than short-lived.
Cash flow projections must also relate to the asset in its current condition, and entities may restructure their operations as part of their response to the pandemic. Management may need to demonstrate that forecast improvements in the financial performance relate to the assets’ or CGUs’ current condition and not to an enhancement or uncommitted future restructuring.
Impacts on expected credit loss (ECL) calculations
Although determined based on the principles contained in NZ IFRS 9 Financial Instruments, the COVID-19 pandemic is also likely to impact the calculation of ECL irrespective of whether a business is using the simplified approach or the full model outlined in the standard.
How can Grant Thornton help?
Those who prepare financial statements will need to be agile and responsive as the situation unfolds, however your resources may be stretched at this time. Having quick and easy access to experts, insights, and accurate information is critical. Our team of experts can support you as you navigate accounting for the impacts of the pandemic on your organisation. Now more than ever, the need for businesses, auditors, and accounting advisors to work closely together is essential.
We provide time critical independent support and advice to organisations who must review or quantify any impairment risks relating to goodwill and other intangible assets caused by COVID-19.
